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COLUMN-If BOJ stands down, only sure thing is lower asset prices: James Saft
July 29, 2016 / 9:43 PM / a year ago

COLUMN-If BOJ stands down, only sure thing is lower asset prices: James Saft

(The opinions expressed here are those of the author, a columnist for Reuters)

By James Saft

July 29 (Reuters) - If the Bank of Japan is indeed turning away from easier monetary policy as a means to fix its economy, then the only thing for certain is lower asset prices.

Upsetting expectations of yet another bold move, the Bank of Japan on Friday announced only a small increase in stimulus by increasing programs which buy equities and make dollar loans to exporters. In addition to focusing its new efforts entirely on private assets and institutions, the BOJ said it would hold a "comprehensive" review of its monetary policy framework at its September meeting.

This immediately touched off highly disparate speculation: that the review would lead to everything from direct "helicopter" financing of government spending to a wholesale retreat from its policy of recent years of buying up more of the universe of Japanese government bonds and taking interest rates further into negative territory.

Neither outcome may be likely, and on balance it is usually safer to expect matters to continue more or less in the direction of travel they have gone thus far.

Still, given the relatively poor results extraordinary policy has achieved thus far, and considering the growing costs and unwanted side effects of asset buying and negative rates, a break of some kind is more likely than any time since the beginning of the Abenomics experiment in deflation fighting.

"We do not believe it will be possible for the BOJ to achieve its inflation goal, or any inflation whatsoever, while the nation is depopulating: We believe deflation is the natural companion of a shrinking population and economy, just as inflation is the natural consequence of a growing population and economy," Carl Weinberg of High Frequency Economics wrote in a note to clients.

If the BOJ steps back along the policy path it's taken, two questions arise: the hideously complex one of what it means for the economy and the relatively simpler one of what it means for investors. There is no telling what, save immigration or an increase in the birth rate, will end Japan's persistent deflation.

The one fairly clear impact of the policy of lowering interest rates and buying assets has been, as you would expect, to make those assets higher in price than the cashflows they generate would otherwise justify.

DISCOUNTS AREN'T ALWAYS CHEAP

Remove the stimulus and expect financial assets, unless something else fundamental changes, to revert back towards a lower price.

During the era of extraordinary monetary policy the assets which have done best have been those with the longest duration, like stocks and real estate.

While most bonds have maturities, stocks, in theory, are perpetual in that you own a right to a share in the cash flows they generate forever, or until you sell your share of the company or it sells itself or fails.

The longer the duration an asset has the more sensitive its price is to the discount rate you use to value it. The lower the discount rate, the higher the valuation. QE and very low or negative interest rates have, at the very least, coincided very neatly with the phenomenon of higher valuations for assets with longer durations.

The promise of cash flows in the future rises as the present interest rate falls.

"The trouble with returns that come from falling discount rates is that they represent an increase in the present value of the asset without any increase to the cash flows to the asset class," Ben Inker, head of the asset allocation committee at fund house GMO said in a note to clients.

"The future expected return to the asset has fallen, and in a way that more or less precisely counteracts the increase in current value. In other words, the present value of the assets has risen but the future value of the assets has not." (here)

Investors have, in effect, been borrowing from their future returns, enjoying capital gains now without the believable promise of better cashflows down the road to justify these gains.

If interest rates rise, as you might expect them to in Japan if the BOJ backs away from extraordinary support, then prices of longer-duration assets like equities or real estate would fall.

You might, very conceivably, have a recovery in which the prospects and cashflows of companies do improve but not enough to outweigh the effect of the rising interest rates used to figure their future value.

None of this is to say that extraordinary monetary policy was a poor choice, in Japan or the U.S.

But investors in riskier longer-duration assets will suffer if it is withdrawn. (Editing by James Dalgleish)

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